Nov 10, 2011

Desperate attempts to catch Risk in new regulatory standards like Basel (II/III) for banks and Solvency (II) for insurers seem a dead end street....

What is happening?

That's the question we're about to answer in this blog!

Here are some observations:

Risk Weighting
All new risk valuating standards are based on Risk Weighting. Some assets (or liabilities) are assumed to be more risky than others. In practice, every asset class that has been identified as more or less 'safe', has turned out to be risky after all. E.G., government bonds where - until the 2011 crisis in Greece - assumed to be risk free. Unfortunately, nothing could be further from the truth...

Nothing in life is risk free

Tier Ratio's
Instead of simple 'Equity to Asset Ratios', Tier 1 & 2 ratios where developed. These Tier ratios only take a fraction of the total assets into account. This leads to 'Equity to Risk-Weighted Assets Ratios' that insinuate adequate, substantial and reassuring 10-15% Capital ratios, while - in fact - they're not! These kind of ratios are misleading and create a false sense of safety....

Tier Ratios lead people up the garden path

Tail Hide and Seek
As more and more risks are valued, regulated and urge for extra capital requirements, financial institutions will try to create extra return on risks that are formally not or only 'light weighted' measured. This way substantial risks are 'pushed' into the tail, fat risk tails are created and the sight on the real risks in the company becomes misty.

Overregulation decreases the effect of good risk management

Illustration: Comparison 'Deutsche Bank' - 'Bank of America'
To illustrate what is happening, let's compare a giant like "Deutsche Bank" (DB) with the number one on the banking list, the "Bank of America" (BOA).

Financial Ratios

Deutsche Bank

Bank of America

(x 1 bn $) Year:

2010

2009

2010

2009

Assets (A)

1906

1501

2265

2230

Liabilities (L)

1855

1463

2037

1999

Shareholder Equity (SE)

49

37

228

231

SE / A - Ratio

2.6%

2.4%

10.1%

10.4%

---------------------------------

Risk-Weighted Assets (RWA)

346

273

1456

1543

Assets (A)

1906

1501

2265

2230

RWA / A - Ratio

18%

18%

64%

69%

---------------------------------

Regulatory Capital (RC)

49

38

230

226

Risk-Weighted Assets (RWA)

346

273

1456

1543

Total Capital Ratio

14.1%

13.9%

15.8%

14.7%

---------------------------------

Tier 1 capital

43

34

164

160

Risk-Weighted Assets (RWA)

346

273

1456

1543

Tier 1 Capital Ratio

12.3%

12.6%

11.2%

10.4%

Although both banks have more or less the same 'Tier 1' and 'Total Capital Ratio', their individual risk profile is completely different.

In the case of DB only 18% of the assets are assumed (marked) risky, while in the case of BOA around 64% is assumed risky and taken into account for a risk weighted solvency approach.

Notice that the simple gross 'Equity to Asset' Ratio (E/A-Ratio, or in short 'EAR') of DB is only 2.6%, while the similar ratio of BOA is around 10.1%. If DB would be hit by an 5% impact loss, it would be in deep trouble.

Reflections

Our risk models have become too sophisticated and don't cover the area of 'Unkown Risk' enough. Unintentionally rand controversially, risk regulations and models make us implicitly sweep our real risks under the carpet. In principle Risks can be categorized as:

Known Risk Measured

Known Risk Unmeasured

Unknown Risk

Hidden Risk (knowingly or unknowingly)

It's time to admit that no asset or liability is completely free of risk and there's an overall substantial probability that risk - by definition - will hit eventually from an unexpected corner. To put things in perspective: In the 19th century, banks funded their assets with around 40-50% equity.

Conclusion
Including 'Unkown Risk', a simple gross E/A-Ratio (EAR) of a magnitude of 15-25% (across the total assets) would probably be the best kind of guarantee to accomplish a more sustainable financial system in the world. The new EAR could be best defined as the sum of an actuarial underpinned percentage on basis of the underlaying calculable covered risks and a TBD overall 10% 'add up' for unknown risks:

Aftermath: 'Avatar Ratios'
To rate a company (bank), often it's not enough to look at just the traditional financial ratios. An interesting way to additionally rate a company in a more sophisticated way, is with the help of so - by me - called 'Avatar Ratios'.

Additional to financial ratios, 'Avatar Ratios' tell you more about what the intentions, (real) important issues and the 'drive' of a company and its employees are.

An 'Avatar Ratio Analysis' gives you more or less 'the embodiment' of all what drives a company. It can be constructed by making a word analysis of a crucial document or annual report of a company. In short: You simply download the annual report (or any other company characteristic document) and analyze it with a 'Word Frequency Counter' like WriteWords.

With the help of WriteWords we first create (on line) a frequency table. Next we cut out irrelevant words like 'and', 'the', etc.

Here are the results:
(1) a scrollable frequency table of all relevant words
(2) a 'Top 22 words' frequency table

In most cases - like this one - the result of simply putting the first 10 to 15 words in the top of the frequency table behind each other, is astonishing: It creates a kind of 'Identity Statement'. Here's the result for IAA's strategic plan, where even more than 20 words give a beautiful comprised identity statement:

Let's now go back to our banking case and compare 'Deutsche Bank' (DB) and the 'Bank of America' (BOA) with the help of a simple Avatar Ratio Analysis.

The Avatar Ratio Analys presents the word frequency (absolute numbers) and their relative frequency (= word frequency / total number of word in document). Here is the result:

Avatar Ratios

Deutsche Bank

Bank of America

Freq.

Perc.

Freq.

Perc.

Governance

109

0.06%

25

0.02%

Risk

1458

0.79%

852

0.53%

Control

273

0.15%

156

0.10%

Total G+R+C

1840

1.00%

1033

0.64%

------------------

Client/Customer

359

0.20%

250

0.15%

Shareholder

169

0.09%

162

0.10%

------------------

Transparent

15

0.01%

2

0.00%

------------------

Employee

153

0.08%

63

0.04%

Director

40

0.02%

23

0.01%

------------------

Profit, Income

1001

0.54%

835

0.52%

------------------

Tot. nr. of words

161579

100%

184048

100%

Although I'll leave the final conclusions up to you, here are some remarkable observations:

Total number of words

Both companies (DB and BOA) need an enormous amount of words to explain their environment (clients, shareholders, rating agencies, etc) the essentials about what's going on in their company in a modest calendar year.

To read an annual report of about 170,000 words, it would take an average reader (reading speed 200 to 250 words per minute) about 10-12 hours.

Perhaps you, as an actuary, can read faster ( test it!: speed reading test ), but even at a speed of 500 wpm it would be an enormous task (5-6 hours) to fulfill.

Governance, Risk & Control
It's clear that DB puts much more energy (+60%) in communicating about themes as Governance Risk and Control than BOA. Also is clear that DB is far more transparent in its communication than BOA. This does (of course) not imply that BOA's risk and control frame is inferior to DB's. It could even be the opposite. It just shows that (and how) BOA handles and communicates differently (less open) from DB.

Profit, Income, Shareholders + Clients and Employees
DB and BOA weight Profit, Income and shareholders on more or less the same level. Both rank client/customer above shareholders. DB gives 'clients/customers' as well as employees double the attention of BOA!

At last
Next time you report to your board, include an Avatar Analysis of your report in your presentation!

Actuary Info
Let's conclude with an example of a more modest and smaller actuarial giant: Actuary Info

Presentation Tip
Next time you give a presentation, instead of summing up the standard dry bullet points, replace them by a Wordle cloud.

Your audience will be spellbound , 'turn their head', 'look for expected words' and 'immediately grasp the relative size of the issues mentioned'. All resulting in (1) you - the presenter - will have much more attention and (2) the facts shown on your slides will be longer remembered, because the are 'your visualized words' and therefore will be better memorised...

An AON Example...
Let's end with a simple example from AON's 2010 Risk Survey:

I. Traditional (PPT) Slide Presentation

Risk Quantification Tools Used (2010)

(to measure demonstrable Value Received from ERM Efforts)

Qualitative tools 59%

Industry benchmarks 34%

Earnings/Cash flow/Value at Risk 27%

No use of risk quantification in ERM process 23%

Actuarial analysis 13%

Stochastic/Monte Carlo simulation 13%

Not specified 7%

II. Wordle Presentation

Now..., get your head in the 'Actuarial Word Clouds' an have even more success with Wordle!!!

May 6, 2009

One of the interesting aspects of the Chinese language is that words are like little pictures, pictograms or logographs, the so called 'characters'. Moreover, some words are a combination, or (better) a superposition, of several of those characters.

So the meaning of a Chinese word can be deducted by interpretation of the pictograms and relating them. And, as the saying is "A picture is worth a thousand words", you don't need to be an actuary to calculate the enormous expression-power of the Chinese language. Every word is like a book of words and expresses not only the rational meaning but also the embodied feeling (mood) that goes along with the the formal meaning.

The power of the Chinese language can be illustrated by three simple examples, the Chinese words for Actuary, Computer and Crisis:

No matter how great the danger in a crisis is, it also means a change of circumstances that creates space for new opportunities. It's an art to spot those opportunities when you're in the middle of a crisis.

But what if you're caught in a storm crisis:

Golden Rules Crisis Risk Management
In terms of risk management: If you're caught in the storm (trouble) and can't get out, don't try to. Try to get to the eye of the storm, where it's calm.

So when you're in the middle of a (credit) crisis :

Don't run

Set time still (Let time do the work)

Keep your head together

Wait for the opportunity, no matter how hard it is or how long it takes

Jan 19, 2009

Do you recognize this? Sometimes you spend hours copying a simple table from a WORD-document, Internet Page or PDF-file to your (Excel) spreadsheet.What should take about two minutes work, ends in frustration. Finally you decide to fill your spreadsheet by hand.

These times are over. With the next simple javascript application, called

Disclaimer

Maggid is an actuarial professional, and like every actuarial professional or human being, he makes mistakes. Maggid encourages you to do your own independent "due diligence" on any idea that he talks about, because he could be wrong.

Nothing written here, or in my writings at Actuary-Info is an invitation to undertake whatsoever action, in particular to buy or sell any particular security; at most, Maggid is handing out educated guesses as to what the markets may do. Maggid thinks that "The markets always find a new way to make a fool out of you", and so he encourages caution with every action, in particular in investing. Risk control wins the game in the long run, not bold moves.

Additionally, Maggid may occasionally write about accounting, actuarial, insurance, and tax or other specialized topics, but nothing written here or on Actuary-Info is meant to be a formal "advice" in those areas. Consult a reputable professional in those areas to get personal, tailored advice that meets the specialized needs that Maggid can have no knowledge of.

The next additional general Disclaimer is also applicable with regard to Actuary-Info.